Sorting out the options-backdating quagmire

Commentary: How backdating may affect your stocks

JohnShinal

SAN FRANCISCO (MarketWatch) -- Bellwethers such as Apple Computer Inc. have gotten delisting warnings from the Nasdaq Stock Market.

Longstanding technology firms including Comverse Technologies Inc. have seen former top executives charged with securities fraud.

And every week, more U.S. public companies are revealing that they've either launched internal probes into the backdating of employee stock options or are being investigated by federal authorities for the practice.

With each passing day, the bad news mounts concerning the latest accounting scandal to rock corporate America, which has been heavily concentrated in the technology sector.

And because most of the revelations have prompted short-term stock drops for the companies involved -- in some cases, large drops -- it's enough to give investors heartburn.

But while it's easy to get skittish about the so-called headline risk to tech firms tainted by options backdating, not all companies being investigated will suffer the same fate.

How bad the options backdating scandal can get for a company will depend mostly on two things: the accounting practices that companies had in place during the go-go days of the late 1990s, and how top executives react once they're told their company is the target of an investigation.

The management of a large number of companies, including Apple
AAPL, -0.32%
Juniper Networks Inc.
JNPR, -2.08%
Cnet Networks Inc.
CNET, -12.81%
and Altera Corp.,
ALTR, +1.13%
have taken a cautious approach that, while prudent for their executives, is adding to the confusion for investors.

Companies in this camp have delayed filing their latest quarterly financial reports with federal securities regulators because internal probes into past options accounting practices have turned up problems.

Those problems in most cases will force companies to restate results for prior periods, because backdated options will raise compensation costs and thus reduce net income for those periods.

Executives don't want to sign financial reports they may have to restate, because federal laws passed in the wake of scandals a few years ago mean they can go to jail for it.

While that's prudent for officials like Apple's Steve Jobs, who would likely have a tough time managing the rollout of the next iPod from a cell, it results in less disclosure about a company's operations.

Moreover, companies that fail to file timely financial reports risk having their shares delisted by the Nasdaq. Apple has received such a delisting notice.

But while the risk of delisting is serious, it's also remote, because markets like Nasdaq have a built-in appeals process that buys companies months to finish their internal options inquiries and file their reports.

For example Comverse
CMVT
has yet to file a quarterly report, known as a 10-Q, with federal regulators for the quarter ended April 30 and has received a delisting notice from the Nasdaq.

Comverse, which cut all ties to its former CEO and two other top officials and has said it will restate several years worth of results, also hasn't filed an annual report, known as a 10-K, for the fiscal year ended January 31.

But last week, the company said officials with the Nasdaq listing qualifications panel had given it until Sept. 25 to file those documents before the exchange will issue "a final determination to delist the company's shares."

Comverse shares are down nearly 30% since March. 14, when they first said they were investigating past option grants

Comverse wouldn't be the first technology company to have its shares delisted due to improprieties related to options dating. Brocade Communications Systems Inc.
BRCD
and Mercury Interactive Corp.
MERQ
both suffered that fate.

But the generous timetable offered to the company to file its reports suggests that Apple and others who received their first delisting notices this month will have at least several more months to file their second-quarter reports.

If they finish their accounting probe and executives are confident enough to sign and file financial reports, the stock drops caused by options revelations may turn out to be short term.

Already, some mutual fund managers are looking at these companies at potential buy opportunities, as this column previously reported. Read the previous column here.

The case of Redback Networks Inc.
RBAK
a smaller rival of Juniper Networks Inc., shows how a stock can get whipsawed by options-related news.

After the company said on June 30 that the Securities and Exchange Commission and the U.S. Attorney for the Northern District of California were investigating its stock option practices, investors fled for the exits.

Shares of the San Jose, Calif.-based company fell 30% during the next three weeks.

On July 25, however, the day Redback reported quarterly results, the company said in a statement that its own options probe -- conducted with the help of outside accountants -- had turned up no evidence of fraudulent activity, and the shares began to rebound.

By Aug. 14, when Redback filed its 10-Q for the second quarter and said it didn't plan to restate results for any quarterly period, the shares had risen about 15% from their late-July lows.

Although the company still must contend with federal investigators, to whom it supplied the results of its own probe, its share bounce shows how moving quickly can restore investor confidence.

By contrast, companies most at risk for further share drops are those where internal investigations have revealed that executives engaged in behavior serious enough to warrant criminal charges, as was the case for Brocade and Comverse.

While no convictions have been won against those executives, dealing with the criminal inquiries will be a major distraction for new management.

Coupled with the lack of confidence that investors have rightly shown to companies that fail to report accurate financials, that distraction is likely to scare away buyers and keep their share prices depressed.

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